Yield trends and investors search for yield will tend to dominate markets in the short term. In this context, the most important factor over the remainder of 2016 is likely to be Federal Reserve policy as this will have a key impact on the dollar and global asset prices.

Central bank policies overall and the balance between fiscal and monetary policies will also be a key underlying focus as overall interest rates remain at extremely low levels with the risk of an important turning point in the excessive reliance on monetary policy to support growth.

US outlook

The US economy and Federal Reserve policies will continue to have a crucial impact on global currency markets.

The Federal Reserve Open Market Committee( FOMC) had been expecting a further policy tightening in June, but these plans were derailed by the much weaker than expected employment report released at the beginning of June followed by the UK referendum vote to leave the EU.

The following two US employment data releases have been much stronger than expected with a cumulative gain in nonfarm payrolls of close to 550,000. There has also been a further gradual increase in average earnings with an annual gain of 2.6%.

The stronger than expected employment releases help lessen concerns sparked by the weaker than expected 1.2% increase in second-quarter GDP.

The Fed is still uneasy surrounding global growth prospects and the strong dollar is also causing unease, especially given its role in holding down inflation. The risk of falling inflation expectations has been a key factor in deterring Fed tightening, but these concerns should ease and financial conditions are now looser with the US currency declining from peak levels. Overall, there is a strong case for the Fed to raise interest rates slightly in September, especially as a further delay would risk having to tighten more aggressively later on.

Euro-zone outlook

Although growth prospects for the Euro-zone have stabilised with solid expansion in the manufacturing and services sector, the region is still struggling to escape from underlying low growth rates. The expansion is also being driven mainly by Germany with France and Italy still struggling to secure any momentum.

The ECB will maintain its very aggressive monetary policy in the short term with the main refi rate at zero, a deposit rate of -0.40% and monthly sovereign bond purchases of EUR80bn. The bond-purchase programme has certainly been very effective in cutting lending rates which should underpin spending.

Reported inflation has edged higher to 0.1% and the ECB remains committed to bringing the rate up towards 2% as quickly as possible.

Very low interest rates will undermine the Euro directly and it will also continue to be used as a global funding currency to fund flows into higher-yield instruments. The currency will, therefore, tend to weaken if there is greater confidence in the global economy and robust risk conditions. In contrast, the currency will tend to gain ground if risk appetite deteriorates.

Overall, the ECB will find it difficult to push the Euro much weaker and, by the end of 2016, there will be increased speculation of a tapering in bond purchases which could trigger an aggressive covering of Euro short positions.

Japan outlook

The economy remains trapped in a low-growth environment, with the government and Bank of Japan still battling to beat deflationary pressure.

The government has launched a fresh JPY28.1trn spending package to boost the economy with over JPY7trn in direct spending. To some extent, a looser fiscal policy will ease pressure on the Bank of Japan to relax monetary policy further, but the central bank has continually missed its 2% inflation target with the bank’s preferred rate still below 1.0%. There is also strong pressure for the bank to complement fiscal policy with further aggressive action to curb deflationary pressures.

The Bank of Japan will undertake an extensive policy review for the September policy meeting. Overall, monetary policy is likely to be eased further which will put downward pressure on the yen

UK outlook

The EU referendum decision to leave the EU has injected major uncertainty into the outlook and will represent an important shock to the economy. From an optimistic viewpoint, global financial turbulence has been minimal after the initial knee-jerk reaction and overall financial conditions are actually slightly easier.

There is still very little in the way of hard evidence on the actual UK impact and the overall data suggests consumer spending has held firm. There has, however, been a sharp deterioration in business surveys with investment liable to be the principal casualty

The Bank of England has acted aggressively to relax monetary policy with interest rates cut to record lows of 0.25% while asset-purchases have been re-started which has pushed gilt yields to record lows. The bank has ruled out negative interest rates as a potential option, but is expecting to cut rates even further before the end of 2016. The government is also set to relax fiscal policy within the next 2-3 months. There will be increased fears over the twin budget and current account deficits.

The overall Sterling fundamentals will remain very fragile and yield support will be weak. Overall Sterling weakness is likely to be essential to rebalance the economy and unavoidable given the overall fundamentals

Chinese outlook

After a major scare surrounding growth conditions early in 2016, there has been some overall stabilisation in confidence with aggressive credit expansion having a significant impact in supporting demand while the yuan has stabilised for now. Immediate fears of a hard-landing have faded, although the overall debt profile remains extremely worrying and relief could be short lived. The most likely outcome is for a slight net improvement in conditions over the next few months before fresh turbulence in 2017.

Global outlook

Global central banks will continue to pursue aggressive monetary policies over the next few months and money supply growth is expanding at a stronger rate. There is, however, also a growing acceptance that monetary policy is becoming increasingly ineffective in supporting demand and there is likely to be a greater emphasis on fiscal policy to support growth over the next few months.

Greater confidence surrounding global growth is likely to underpin commodity prices with WTI crude finding support below the $40 p/b level for WTI with industrial commodities also firmer. Overall demand for defensive assets is likely to be slightly weaker.

Further Fed tightening would undermine emerging-market currencies, although the impact will be manageable if there is confidence in the global economy.

Risk factors

The US presidential election is a potentially important risk factor. A victory for Republican candidate Trump would risk major turbulence surrounding US asset prices and could also cause major instability surrounding Federal Reserve policy.

The Chinese debt position remains precarious while fresh credit injections are becoming increasingly ineffective. At best, rising defaults will increase banking-sector bad loans and government debt with the threat of a much more severe collapse in conditions which would undermine the global outlook.

A sharper than expected increase in US inflation would risk a sharp sell-off in US bonds and force the Federal Reserve into a much more aggressive tightening cycle to head-off inflation which would risk recession conditions during 2017.

There is still an important risk of political turbulence within the Euro-zone, especially given severe economic pressures in Italy. The greater risks are likely to be in 2017 with a focus on French and German elections.

The underlying chase for yield will increase the risk of price distortions, asset-price bubbles and financial-market instability.

Summary

The Federal Reserve is walking a tightrope and there are important risks that either rates will not be increased or that it will be forced into a faster pace of tightening. Overall, however, the most likely outcome is a small rate increase while the ECB maintains a very loose policy through the end of 2016 and the Bank of Japan eases further. The dollar should maintain a firm tone, but will face considerable barriers to extending gains given overall positioning in favour of the currency.